Investors Have a Defense Stock Hangover, but the Spending Party Hasn't Even Started

We think the U.S. midterm elections slated for Nov. 6 could provide investors with an entry point to high-quality, moaty defense companies. However, even if the Democrats win back the House of Representatives (possible) and the Senate (less likely), the increases in the fiscal 2019 defense budget are close to being locked in, and we also don’t expect large decreases in U.S. defense funding for fiscal 2020 or 2021. Provided a Republican occupies the White House, we think the House and Senate budget hawks will probably go along with any spending plans passed in their respective chambers if the Department of Defense receives budget increases equal to nondefense agencies. That said, we do expect more volatility in the defense names we cover as we approach the midterms and potentially following the election as well.

A Democratic speaker wielding the gavel in the House remains a more distinct possibility than the Democrats flipping the Senate, in our view. The Democrats need to win 23 seats to take back the House. The Cook Political Report believes 19 Republican seats in the House are vulnerable going into the midterms, which means the Democrats would need to win these Republican seats and pick up four additional seats in districts that have been leaning slightly Republican. Although we don’t think it’s likely, should a Democratic sweep of the House and the Senate suddenly become more probable, then we expect defense share prices to fall on the back of investor uncertainty stemming from the possibility of a divided government.

The Democrats’ path to Senate control looks more difficult. The Democrats only need to pick up two seats in the Senate to wrest control from the Republicans, and the Cook Political Report, a respected nonpartisan political researcher, categorizes three Republican Senate seats as toss-ups. However, the Democrats are defending 26 seats in the Senate; they will need to keep all these seats and also pick off two out of the nine Republican seats facing an election this November. This suggests to us that Democrats have a long (but not impossible) row to hoe to take back the Senate. Indeed, we think a best-case scenario for the Democrats would be a net gain of perhaps two seats, giving the party a 51-49 majority. On the other hand, we believe it’s possible that the Republicans could add to their seat count, providing them a bit more breathing room on votes.

We’ve mapped presidential approval ratings going into each midterm election since 1946 to the number of seats lost (or won) in the House and the Senate. At first glance, the data confirms the adage that a sitting president’s party performs poorly in the midterms. Indeed, the president’s party has picked up seats in the Senate only five times in the past 18 midterm elections since 1946 and only two times in the House over the same period. Our regression that uses the president’s approval rating to explain Senate midterm election performance lacks explanatory power (r-squared equals 28.4%), but the model does better with the House (r-squared of 41.9%). Based on recent Trump polling, which indicates an approval rating of around 42%, our model predicts the Republicans losing 40 seats in the House, implying a Democratic-controlled lower chamber once the midterm election dust settles.

Although we have good visibility through late 2019, the Budget Control Act caps last through fiscal 2021, which means Congress and the president will need to find a compromise that revises the Budget Control Act law and raises spending levels, or the caps will come into force via sequestration. Although it’s tempting to think that a Democrat-controlled House might force the government into sequestration, we expect a bipartisan agreement to repeat itself in calendar 2019, as part of the congressional debate over the fiscal 2020 budget. If it’s similar to the previous bipartisan compromise, which encompassed two years of budgets, the agreement should effectively secure funding for the Department of Defense through fiscal 2021. However, a presidential election is slated for November 2020, which makes us think a one year funding solution is more probable.

Looking further out, in the most recent Future Years Defense Program, the Department of Defense forecasts its discretionary budget authority growing to $751 billion in fiscal 2023 up from the $675 billion budgeted for fiscal 2019. While we think the near-term increases baked into the Department of Defense’s forecast are secure--indeed, our forecast calls for budgeted defense authority addressable by industry to land above the FYDP in fiscal 2020 and 2021--we remain less sanguine post-2021, given persistent budget deficits combined with the possibility of a Democratic president in 2020. Should the White House switch parties, we believe that we’d return to the pre-Trump era, which saw an alliance between the Democrats holding up defense spending increases with demands for nondefense spending and the Republican budget hawks who prioritized lower spending across the board regardless of whether it was for defense or not.

Our more negative long-term forecast for Department of Defense funding accessible to contractors is underpinned by our view that budget deficits coupled with mounting U.S. federal debt will pressure Congress and the White House to rein in spending. Per the Congressional Budget Office’s April 2018 forecasts, the budget deficit will hit $1 trillion by 2020, equating to 4.6% of GDP, up from 3.5% in 2017. Budget deficits will continue their steady march upward, reaching $1.35 trillion in 2025 per the Congressional Budget Office forecast. These forecasts assume GDP expands by 3.3% in 2018 and 2.4% in 2019 and then falls toward 2% over the long term. We think a recession could push budget deficits to 6% or more of GDP, depending on the severity of the economic downturn. This could result in calls to control spending. The U.S. defense budget historically averages about 50% of annual federal discretionary spending, which makes it the most logical and easiest place to find savings for politicians loath to touch mandatory spending accounts like Social Security and Medicare.

The Best Defense Is a Moat We've long maintained that the defense industry is awash in economic moats; each major defense contractor we cover garners at least a narrow moat rating and several possess wide moat ratings. Major U.S. defense contractors derive their moats primarily from intangible assets and switching costs. Intangible assets emanate from these contractors' deep knowledge of the highly regulated defense market both in the United States and internationally. Technical knowledge built up over decades of cooperation with the U.S. and international militaries adds to their regulatory knowledge and strengthens these intangible assets. In addition to these regulatory and technological factors, the classified nature of many defense contracts creates barriers to new entrants. The bespoke and complex products developed by defense contractors also create a high degree of asset specificity and high switching costs for customers. Recreating these assets would entail significant costs for the Department of Defense, which underwrites nearly all its suppliers' product development costs. Because defense products are mission-critical, a high cost of failure reinforces these switching costs.

These moat sources create competitive advantages for the U.S. defense primes that allow them to consistently earn returns above their cost of capital even in challenging market environments. We anticipate returns to remain quite durable for the defense names we cover, with all the defense primes garnering wide moat ratings and the one mezzanine contractor we cover,

Should the Department of Defense demand pricing concessions from the U.S. defense majors and/or pressure U.S. defense contractors into fixed-price development programs, then returns on invested capital could take hit across the industry. However, we maintain there are limits to this and note that roughly half of the Department of Defense’s contracts awarded are sole source, meaning only one company competed for the work. Furthermore, we would point to Northrop’s recent no-bid decisions, which were driven by poor economics on both programs, as an example of how contractors can and do push back.

In our view, the most significant risk to defense contractor moats remains the possibility that the Department of Defense increases its use of fixed-price development contracts and potentially a clawback of company tax savings from the recent reduction in the U.S. corporate tax rate. We’ve observed a shift toward fixed-price development contracts, but we’re not downgrading any moat trend ratings across the U.S. defense industry because we think this shift has already played out and returns have held up quite nicely. Regarding the possibility of the Department of Defense recouping the tax savings, we haven’t seen any vocal proponents of this in the Pentagon yet.

Broadly speaking, the U.S. government uses two types of contracts: fixed-price contracts and cost-reimbursement contracts. Under the former, prices are fixed--but typically subject to escalation at the rate of inflation--which means the contractor shoulders the risk of cost overruns. On a cost-plus-fixed-fee contract, the government pays for all allowed expenses up to a predetermined limit and provides a margin or “fee” to the company. The U.S. government also uses several variants of fixed-price contracts. Under a fixed-price contract, a ceiling price is specified, and if breached, the contractor must absorb all costs above the ceiling.

Contracts for mature production programs almost invariably feature firm fixed-price approaches, which means contractors that successfully control costs can easily garner operating profit margins north of 10% with the caveat that they take on more risk. Recently, however, we’ve noticed a shift toward fixed-price-incentive firm development contracts on some major programs like the Air Force’s KC-46 tanker and T-X trainer aircraft as well as the Navy’s unmanned MQ-25 Stingray. This shift is confirmed by the Government Accountability Office, which found that within the $50 billion-$70 billion of incentive-type contracts the Department of Defense has awarded annually over the past several years, fixed-price incentive contracts have taken an increasing share.

We think that while the use of fixed-price development contracts will continue, the shift toward these types of higher-risk contracts for industry has already played out, and there will still be plenty of plain-vanilla cost-plus contracts like the B-21 and Columbia-class submarine. We note that Northrop walked away from the MQ-25 Stingray competition, citing the fixed-price development contract as a concern. Although the Department of Defense is a monopsony, the ability of the major contractors to leverage their market power due to the highly concentrated U.S. defense industrial base makes us believe that blanket use of fixed-price contracts, which would significantly increase contract execution risk across the defense industry because the companies and not the U.S. government would be responsible for cost overruns on development work, is neither practical nor possible.

Regarding the impact of tax reform on the defense industry, it’s conceivable that contractors will have to give back some of their tax savings in the form of lower pricing. Federal Acquisition Regulation regulates operating margins for defense companies, which means net margins can increase on the back of lower tax rates and contractors don’t have to share these savings with the U.S. government. Conceivably, FAR could be changed to focus on net margins or to consider the lower tax rate, but we don’t think this would happen overnight, and it would be legally challenging (if not possible) to apply the change to existing contracts. Moreover, defense companies are reinvesting part of their tax savings in internal initiatives that should ultimately benefit their U.S. government customers. Thus, we continue to think the possibility of lower taxes generating steep Department of Defense pricing concession demands remains remote. Lastly, we’d point out that multiple areas of defense hardware are no longer competitive--for example, in missiles, Lockheed and Raytheon control 97% of the market--which makes competing away the increase in aftertax profits an unlikely event.

We Finally See Some Value on the Back of Faster Growth U.S. defense names have outperformed the broader market over the past several years, prompting some investors to expect underperformance for 2018 and 2019. However, we believe that while defense stocks may experience near-term softness going into the midterms, they should recover and enjoy a tailwind thanks to outlay growth through late 2018 and into 2019. Although we see defense budget growth reversing in 2021-23 due to growing mandatory spending requirements--primarily for Medicare, Medicaid, and Social Security--we believe strong moats across the defense companies we cover combined with their proven ability to weather defense cycles means that long-term investors will still be well served holding wide-moat defense stocks that trade at attractive valuations.

Over the past five years, the U.S. defense majors have outperformed the S&P 500. Most of this outperformance came as defense budgets bottomed out in 2015 but only modestly crept up in 2016 and 2017. The defense sector has pulled back in recent months, and we think this has been driven in part by stretched valuations. Indeed, we were cautioning investors that the sector looked overvalued earlier in 2018. At the same time, news began to surface that President Donald Trump would meet with North Korea’s Kim Jong Un in mid-May, which in our view lessened the chance of war breaking out on the Korean peninsula. As a result, and despite solid first-half earnings, nearly all of the U.S. defense majors have underperformed the broader market over the past six months.

Despite the recent pessimism, we think accelerating growth in late 2018 and into 2019 augurs well for defense investors. Based on our regression model, we’ve increased our 2019 growth rates for defense names across the board and now envision average annual organic revenue growth rates approaching 5% for most industry players from 2018 to 2022, with faster growth from 2018 through 2020 and 2019 revenue growth coming in above 8% year over year. We’re sitting well above consensus for 2019, but our more bearish view on long-term U.S. defense budgets due to the fiscal squeeze coming from mandatory spending and lost tax revenue means that we’re below consensus in 2021. Across the major defense companies we cover, we expect Raytheon, Boeing’s defense hardware business (services revenue isn’t broken out between commercial and defense), and General Dynamics’ defense businesses will exhibit the fastest organic revenue growth over the next five years.

We believe General Dynamics is the most undervalued defense company we cover. While it operates a business jet unit (aerospace systems), after its CSRA acquisition, defense and government-related revenue will constitute roughly 75% of total revenue and a slightly lower percentage of consolidated earnings. We think investors continue to underappreciate the recovery taking hold in business jets (who can blame them, after scraping the bottom of the market for several years?) and some are also applying a generic conglomerate discount to General Dynamics, despite management’s proven ability to drive value creation for shareholders.

We think wide-moat General Dynamics’ monopolylike position in shipbuilding, large backlog in ground combat vehicles, and industry-leading business jet brand, Gulfstream, will generate top-line growth and significant margin expansion starting in 2020. Despite margins coming under pressure in 2018, we anticipate flat to slightly increased operating margins in 2019 coupled with more significant margin expansion in 2020. Operating cash flow should follow suit, with this metric breaching $5 billion by 2020 in our model, up from about $4 billion in 2018. The shares continue to trade at a discount to our $220 fair value estimate.

General Dynamics’ ground vehicle business, combat systems, is poised for significant revenue increases thanks to international work and large contracts with Saudi Arabia and the United Kingdom. In addition, our sense is that U.S. spending on tanks and wheeled combat vehicles will remain elevated over the near term due to the North Korean and Russian threats. The U.S. Army wheeled and tracked combat vehicle budget should rise about $1 billion year over year in 2019 due to tank upgrades and modifications (specifically, the M1A2 SEP v3) in support of the European Deterrence Initiative.

Marine systems operates in a duopoly for large U.S. Navy shipbuilding and enjoys a monopolylike position in submarines. Although Congress and the White House continue to vocally and publicly support a 355-ship Navy, our assessment of the Navy’s shipbuilding plans and retirements suggests this number is unrealistic and 315-320 ships by 2030 remains more likely. That said, we do think the Navy will prioritize General Dynamics’ Columbia-class ballistic missile submarine over other ship programs, given the pressing need to replace aging Ohio-class submarines. Columbia-class development work will ramp up and the associated cost-plus contracts will create some margin pressure in marine systems’ submarine business line. The first submarine will begin construction in the U.S. government’s fiscal 2021 under a cost-plus contract with delivery slated for fiscal 2027 per the U.S. Navy’s shipbuilding plan. Marine systems is slated to begin construction on the next Columbia sub in fiscal 2024; this work would most likely go under a fixed-price contract, enabling higher margins.

The Navy forecasts two Virginia-class attack submarines, a mature program with margins that are probably hovering in the double digits, to be under constant construction over the next few decades. However, we think Virginia-class construction may fall to one submarine under construction in years where the Columbia class is also drawing resources at General Dynamics’ Electric Boat facility in Connecticut. In contrast to the adverse mix effects in the submarine business, the surface combatant business, which we estimate at less than 20% of revenue at marine systems, should experience improving margins. Management has put most of the challenges on the first DDG-1000 ship and the DDG-51 restart behind it, and the company recently announced that a multiyear procurement contract should be awarded on the DDG-51 program in 2018.

General Dynamics’ recent focus on expanding the scale of its defense IT services business, which is growing via the $9.7 billion acquisition of CSRA, is a necessary move, in our view, given the need to gain scale in the services market to better control overhead costs embedded in contract bids. Thus, we posit that cost efficiencies, as opposed to management’s discussion of a broader portfolio of offerings, drove the deal, and generally we have more confidence in cost synergies than in ambiguous revenue synergies. Nonetheless, we do think General Dynamics’ new information technology business will also have an attractive position in intelligence services work (roughly one third of revenue in the business), which we believe possesses a wide moat because of its classified nature, compared with the narrow moat for most services work.

In the business jet unit, aerospace systems, we think jet deliveries have found a bottom and the aerospace segment will begin growing again. Its 2,000-plus fleet of aircraft will provide recurring services revenue, and the 2018 acquisition of Hawker Pacific is expanding General Dynamics’ services capabilities in business aviation. Although aerospace systems margins will contract in 2018, we’re convinced that General Dynamics can maintain industry-leading business jet margins even as it transitions to the new G500 and G600 aircraft.

Although we prefer General Dynamics, some investors object to the business aircraft exposure in the company’s portfolio due to the protracted downturn in the business jet market. We’d point those interested in defense pure plays to Raytheon and Northrop Grumman, both of which trade at a discount to our fair value estimates and possess wide moats.

Raytheon remains more exposed to international defense markets (international arms sales account for a bit more than 30% of revenue) than Northrop, and its missiles and munitions business means it’s more exposed to the U.S. military’s operations tempo. The company’s missile defense business also remains a strong growth driver in the portfolio, with its flagship Patriot system enjoying significant international demand as well as its missile defense radars. Growth in classified business at Raytheon has been weighing on margins due to early-stage development work that can be more prevalent on black programs; we estimate that classified activities are about 20% of Raytheon’s total revenue. We expect management to upgrade its operating cash flow guidance for 2019 and 2020 later this year on the back of the company’s large pension contributions and the pension plan’s purchase of an annuity, which moved a sizable amount of pension obligations off the balance sheet.

For Northrop, its positions on the F-35 and B-21 bomber, as well as a resurgence in the F-18 line, are key business drivers. In addition, the company is digesting its $9.2 billion purchase of Orbital-ATK, which closed in the second quarter; we appreciate Northrop’s postacquisition portfolio that enjoys increased exposure to missile defense and space systems. However, investors will have to get comfortable with Northrop’s classified business; these activities are a black box and likely to expand to 30% of total revenue by end of this decade, from around 25% today. Finally, the transition to new CEO Kathy Warden will take place at the beginning of 2019. We think she will prove to be an excellent steward of shareholder capital, but the market seems unjustifiably wary because of the large shoes she’s filling (outgoing CEO Wes Bush has served in the role since 2010) and because she hasn’t operationally managed a major aircraft development and manufacturing program in her career.